Hedge Funds from the Institutional Investor’s Perspective

As a consequence of its greater maturity, the hedge fund industry has extended its investor base to institutional investors, who are now faced with a large number of product offerings including not only single hedge funds, but also funds of funds and, more recently, investible indexes.

Senior Research Engineer, EDHEC Risk and Asset Management Research Centre

Although the existing literature seems to concur on the interest of hedge funds as valuable investment alternatives, there still remain a large a large number of institutional investors who wonder whether they should invest in hedge funds, and more importantly, how they should do it. In order to address these questions, this chapter looks at the risk factors in hedge fund strategies and attempts to assess the diversification benefits investors can expect from allocating part of their wealth to hedge funds. In addition, this chapter structures the different uses of hedge funds by proposing a separation into the tasks of alpha management and beta management. For both of these tasks, indexes that give a true and fair view of particular hedge fund strategies are a necessary tool for the investor. Therefore, this chapter also considers construction methods that allow designing investible hedge fund indexes that keep all defining properties for a good index. Finally, a simplified approach that allows institutional investors to use such indexes in order to optimally exploit the diversification properties of different hedge fund strategies is presented.

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